How Electricity Pricing Works in British Columbia

In the midst of a spending blitz, BC Hydro has applied to the BC Utilities Commission (BCUC) to increase residential electricity rates by an estimated 10% per year over the next three years. BC Hydro, which announced the rate changes on December 2, 2010 expects the increase to take effect in April 2011, assuming BCUC approval. The news release explains that the Crown Corporation is investing $6 billion over three years to provide essential upgrades to aging transmission and generation facilities, add significant new transmission capacity, increase capacity at the Mica and Revelstoke dams, and install smart meters in every household.

While all rate-setting proposals are made public on the BCUC’s web site, the fact remains that British Columbians know very little about how their electricity is priced, why it costs what it does, and where BC electricity prices stand relative to other Canadian jurisdictions. BC Hydro’s latest rate change proposal provides us with an opportunity to investigate these, and other, questions in the hopes of better understanding electricity pricing in BC.

This post provides an overview of electricity pricing in BC. Our next post will examine the merits of using rate changes to promote conservation.

The Basics: How electricity prices are determined in BC

There are two different types of approaches to pricing electricity: cost-based pricing, and market-based pricing. BC uses cost-based pricing, and because it relies mostly on large hydro-electric dams that were built decades ago, its electricity prices are very low compared to most other jurisdictions.

Electricity rates in BC are primarily influenced by stipulations within the “Heritage Contract,” which guarantees that BC customers continue to benefit from low-cost Heritage Resources, defined as the legacy of existing generation, transmission and distribution infrastructure, including the large dams built along the Peace and Columbia Rivers in the 1960s and 1970s. According to BC Hydro, the purpose of the Heritage Contract is to maintain low electricity rates for customers while maintaining a secure and reliable energy supply. The Heritage Contract also stipulates that rates are to be maintained at a level consistent with BC Hydro’s annual revenue requirements while still remaining affordable to ratepayers (BCUC, 2003).

The most common form of rate determination in BC is known as “historical average cost pricing”, which is the method used by BC Hydro to determine the price of the guaranteed quantity of electricity to be provided by its Heritage Resources (BCUC, 2003). Under this pricing scheme, rates equal the average cost of producing one unit of electricity over the lifetime of a given generating facility. The average cost is determined through calculation of the “levelized unit cost” (LUC), which divides the capital and operating costs of a facility by the total energy that is projected to be produced by the facility over its lifetime (Healey, 2010). This common metric allows average costs for different generating facilities to be compared.

The levelized unit cost of BC Hydro’s existing hydroelectric power – which accounts for approximately 90% of BC Hydro’s Heritage Resources – is extremely low at approximately 5.3 cents/kWh. This early investment in big hydro is why BC Hydro is able to maintain such low electricity rates. Among major Canadian cities, Vancouver’s residential electricity rates are third lowest in the country, at 7.79 cents/kWh, behind only Montreal and Winnipeg (Hydro-Quebec, 2010). There are actually three classes of prices depending on the type of user: residential, commercial, and industrial. Commercial and industrial ratepayers pay a lower rate than residential customers, primarily because of the economies of scale ( lower transmission costs per unit) of supplying electricity to large commercial and industrial customers (Healey, 2010).

As demand for BC electricity grows, BC is adding new sources of supply. Given the remarkable economies of BC’s Heritage Resources, any new source of power will be more expensive than historical prices. As a result, increased supply puts upward pressure on prices.

Marginal Cost Pricing

The main alternative to historical average cost pricing is the marginal cost of new supply, or market-based pricing. Under this pricing scenario, the electricity price fluctuates with movements of the intersection of the supply and demand curves. The supply curve illustrates the marginal cost of new electricity supply (i.e., the cost of producing one additional unit of electricity) at various levels of production; conversely, the demand curve represents the benefit to customers that accrues from a one unit increase in production. At the intersection (equilibrium) point, the benefit to consumers and the cost of producing an additional unit of electricity are equal, which implies that benefits are maximized while costs are minimized.

Historical average cost pricing artificially maintains electricity rates below this equilibrium. While this provides a benefit to all classes of consumers through lower rates, it also promotes overconsumption of electricity (Healey, 2010).

BC Hydro engages in cross-border electricity trading, which also uses market pricing. Electricity trading, which is undertaken by Powerex, a BC Hydro subsidiary, is affected by factors such as water level variability, unforeseen power outages, and routine (i.e., seasonal and time-of-day) spikes in demand. Reflecting the basic laws of supply and demand, market prices will rise and fall as the balance between supply and demand changes. When BC has a surplus of electricity and its trading partners are facing a shortage, the price for BC Hydro exports will go up. In contrast, if demand for electricity in the region is low and abundant supply is available, the price will drop. Market prices on the “spot market”, as it is called, are highly volatile, often changing on an hourly basis (Healey, 2010).

Much has been made recently of the contribution of independent power producers (IPPs) to electricity prices. Independent power producers are privately-owned, and often small, generators of electricity. BC Hydro periodically solicits proposals from IPPs, though this activity has increased in scope and visibility under the BC Liberal government. BC Hydro generally buys electricity from IPPs at a rate that exceeds the current spot market price, leading to concerns that BC Hydro is paying too much for this kind of power. It is uncertain whether the prices given to IPPs will turn out to be too high over the long term. One important consideration is that the contracts with IPPs lock in a set price for electricity that may end up being cheaper than buying the same quantity of electricity on the highly volatile spot market (Healey, 2010).

Conservation pricing: A justification for higher rates?

Many environmentalists have advocated higher electricity rates in order to provide customers with an incentive to use less electricity. On October 1, 2008 BC Hydro brought in a stepped rate in order to promote conservation, charging residential customers 6.27 cents/kWh for the first 1,350 kWh they use over a two-month billing period, while charging 8.78 cents/kWh for any quantity of electricity above that initial amount.

In spite of the potential environmental benefits electricity conservation, there are genuine concerns about the relative impact that conservation pricing schemes could have on low-income households. In a subsequent blog post, we will investigate these concerns, as well as other practical implications involved with conservation pricing of electricity.